Why is the value of the pound so important?
Why is the value of the pound so important?
Currency is something we all use every day, whether that’s doing the weekly shop, downloading a film rental or calculating prices at work. A nation’s currency can be in physical notes and coins or, as is the case with the majority of a nation’s monetary supply, digitised via card transactions, bank accounts and on the databases of financial institutions.
What is a currency used for?
If we take a general look at what a currency is actually used for, it is essentially a store of value that can be used by everyone in society. The alternative is the barter trade, but if you are a sheep farmer that wants to buy a mobile phone, you’d be hard-pushed to find a mobile phone retailer that wants to swap seven or so live sheep for a smartphone – you would have to find someone that wants the sheep in exchange for something the phone retailer wanted. This would all take a very long time and be incredibly complicated; hence the need for a universally accepted currency.
As you can see, a currency makes transactions happen much quicker than bartering and it's clear how having a universally accepted store of value allows everyone in society to participate in trade without having a long chain of transactions.
What are the different types of currency?
Each society has evolved this process and developed its own currencies over time and this process is constantly changing and evolving. Over time, different societies have used commodities ranging from cocoa beans and stones to gold, cigarettes and bags of crisps to store value and enable transactions (just think how you used to trade your packed lunch at school – is a chocolate biscuit worth half a bag of crisps?).
By far the most common form of currency today is electronic currency and electronic money transfers are happening around the world with a mind-boggling frequency, all facilitated by various banking computers, servers and databases.
We have written an in-depth article on gold, so be sure to catch up on that if you haven’t already done so. It outlines the history of how currencies were linked to the price of gold, how that process failed and why most currencies are no longer backed by physical assets resulting in the fiat currency system. Fiat currency is a term that describes a currency with a value that stems from other people’s willingness to accept it, how trustworthy the issuing government is and their relative ability to set and collect taxes on the currency’s transactions.
In the UK, we currently use pound sterling (GBP). In the United States they use the dollar (USD), the Yuan (CNY) in China and the Yen (JPY) in Japan – these are all fiat currencies. Crypto Currencies are evolving to make trade faster in the digital society, whereby people from all over the world want to make instant, cheap transfers to each other via a universally accepted currency. The vast majority of crypto assets are fiat and are not backed by a physical asset.
What is an exchange rate?
Societies need to import goods that are not available domestically and export excess goods to foreign partners. For example, in the UK, we don’t have much success in growing avocados but have a strong demand for them. As a result, enterprising businesses looking to exploit the gap in the market must seek out avocado growers in the Americas, Africa and the Far East and purchase a supply using either their domestic currency, our native currency or a mutually convenient currency, such as US dollars. The same applies to exports, whereby Scottish whisky distillers seeking to fulfil the demand for their products from overseas buyers must decide which currency to accept payment in. This is where the exchange rate comes in.
When it comes to establishing a currency exchange rate, governments have a couple of options. They can either peg (fix) their currency to a larger currency, such as the euro or the US dollar or opt for a floating exchange rate whereby the price is governed by supply and demand.
Some examples of currencies with a fixed exchange rate are:
The Brunei dollar is fixed to the Singapore dollar.
The Croatian kuna is fixed to the euro.
The Lebanese pound is fixed to the US dollar.
The Saudi riyal is fixed to the US dollar.
Some examples of currencies with a floating exchange rate are:
Australia with the Australian dollar (AUD).
Sweden with the Swedish krona (SEK).
India with the Indian rupee (INR).
The UK’s pound sterling is another example. There are various other sub-types of exchange rate regimes, such as inflation-targeting framework, monetary aggregate target and composite exchange rate anchor which are out of the scope of this article but worth looking into if you want a more complete picture of the complexities of foreign exchange.
With a floating exchange rate, an increase in the supply of a currency (i.e. where it is devalued) often leads to it becoming cheaper for foreign buyers and an increase in demand (i.e. where it’s value increases) may result in a price increase for overseas buyers.
Why is the exchange rate of the pound so important?
Most people generally don’t pay too much attention to the pound’s exchange rate unless they are going on holiday and need to buy some foreign currency or if they have noticed the price of certain destinations get more expensive. This is because most of our transactions are undertaken in pounds, the same currency we are paid in.
However, the ongoing fluctuations in the value of the pound against other currencies are part and parcel of a floating exchange rate and the main driver for a strong currency is a strong economy, so it should be of more interest to everyone.
Essentially, foreign buyers of a currency and investors need to know that the pound will maintain its store of value over time and not be eroded by excess supply (such as printing more money). A decline in the value of the pound can be an early indicator that the global markets are losing confidence in the British economy and overseas investors may pull out of UK projects.
Another important factor to consider is how the pound compares to the US dollar as most commodities around the world including oil and gas are traded in US dollars – so even if the price of oil remains level, when the pound falls against the dollar, we all have to pay more for fuel. Therefore, if the price of oil increases and the value of the pound against the dollar falls at the same time, the effect on the pound’s ability to purchase oil is multiplied leading to high domestic inflation.
This relationship between one currency’s value and another can be applied across trade as a whole. Looking back to our avocado example, if the value of the pound falls against the Mexican peso (another free-floating exchange rate), we will end up paying more for our avocados. Conversely, if the pound is strong and buys more Mexican pesos, we will get more avocados for our money and the price will be reduced.
As ever though, there’s more to the value of the pound than just hoping for a strong exchange rate. For example, when a currency is particularly strong, it can make exporters’ jobs more difficult as their product becomes less desirable to overseas buyers. Thinking back to our Scottish distillers, when the pound is weak, overseas buyers may want to buy more whisky as it is cheaper for them, but when the pound is strong they get less whisky for their money and they may turn to other markets such as Canada or Ireland.
What can investors do about a weakening pound?
Investors in the UK may wish to consider investing in the stronger overseas markets if they believe that the pound is going to continue to weaken as the invested returns may also benefit from a boost in the exchange rate. Another option is to consider investing in large UK-based companies that operate all over the world as they will receive a portion of their earnings in foreign currencies and they may benefit from the exchange rate.
Conclusion.
The fluctuating value of the pound against other currencies is something to be mindful of as an investor, alongside other indicators such as inflation, interest rates and the general performances of market indices. However, a strong pound is not always a guarantee of success as exports can decline due to overseas competition, but it can reduce the cost of imports. Conversely, a weak pound may attract overseas investment, boost capital flows and increase exports on the basis that the weak exchange rate offers them more for their money, but it can increase the prices paid by UK consumers. Overall, the UK may fair better in the long term if it is less reliant on imports but maintains strong incentives to overseas investors and reduces barriers to domestic exports.
What’s next?
If you haven’t already done so, please take the time to read our article on Gold as this covers the issue of currency in some detail. If you need help or advice on your personal or business finances or if you want to consider investing to make your money work harder, you can get in touch with one of our advisors for independent financial advice. We offer a free initial consultation and although we are based in Tunbridge Wells, we advise clients across the UK.
Don’t forget, this article offers information about investing and should not be taken as personal advice. Remember that investments and pensions can go up and down in value, so you could get back less than you put in. Tax rules can change and the benefits depend on individual circumstances.